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Thursday, 14 December 2017

Permanent struggle

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Volatile equity markets and a difficult backdrop for structured credit have played havoc with the performance of some listed closed-end funds. Trading at or below NAV appears to be the norm for many, and the permanency of permanent capital has come into question. With some of the exuberance removed, bankers are hoping to be left with a best-in-class market that can finally flourish. Helen Bartholomew reports.

More than a year after the groundbreaking Amsterdam listing of KKR Private Equity Investors (KKR PEI), permanent capital has come into question for a variety of reasons including poor aftermarket performance and difficult primary execution. Many have traded at discounts to NAV, some have been forced to buy back shares, and one has been wound up, highlighting the sometimes temporary nature of so-called permanent capital.

Many that were queuing up for access to permanent capital in KKR's wake, are now reconsidering given the high costs and added reputational issues of coming under intense public scrutiny, with regular NAV reporting.

"For fund managers, the concept of permanent capital is fantastic, but it isn't a free lunch. Many have found it much harder going than they imagined and people have now realised that it isn't as easy as KKR made it look," said Louise Wilson, head of ECM at UBS.

As a consequence of the sub-prime turmoil, London-listed Caliber Global Investment has closed its London-listed fund, while Cheyne Capital Management's Queen's Walk reported US$91m losses and the stock languishes at less than half of the €10 IPO price. Caliber shares traded at a discount of more than 40% to NAV as US residential mortgage-backed securities represented around half of the fund's US$900m of assets. Far from a permanent source of capital, Caliber's decision to return all capital to shareholders came just two years after flotation.

Away from the difficult credit backdrop, failure can also be attributed to structuring errors and over-ambitious targets. "Some deals have been unsuccessful because they were structured solely with the asset manager in mind rather than the end-investor. A few deals have had unattractive structures, suggesting a naïvely optimistic assessment of investor appetite on the part of their sponsors," said Craig Coben, a managing director in Merrill Lynch’s ECM team.

Many have been forced to rethink their size targets during marketing. Brevan Howard's LSE listing of feeder fund BH Macro fell short of its €1bn target, raising just €770m after more than a month of bookbuilding, but at the smaller size, the fund has performed well and continues to trade above NAV.

With an increasing number of permanent capital vehicles (PCVs) to choose from, some strategies for success are beginning to emerge. "Funds need to offer a genuinely differentiated investment proposition and offer something that investors do not otherwise have access to," said Coben.

Fees have been a sticking point in which investors appear to have won the battle. "Fund managers must be prepared to bear the cost of setting up. Investors don't like having to pay set-up fees as it eats into NAV. Those funds that have found another way of financing the set-up have performed better," said Wilson

Structure, quality and differentiation are all important determining factors governing where a fund will trade in relation to NAV, but there is also an element of equity risk involved. "Ultimately, the share price is a function of demand and supply. The NAV provides a reference point, but with a listed fund, you tend to be at the mercy of the market. Where you have a very compelling story and the manager is clearly adding value and delivering on the performance objective, there is no reason to trade at a discount to NAV," said Mark James, executive director, alternative investments at ABN AMRO.

Although there has been some increased institutional interest, participation generally remains limited to private banking networks and high net worth. The primary investment decision rests on the ability of the fund manager to add value, and the opportunity to buy illiquid assets in liquid form. But for most funds, liquidity is low, which is adding to the share price pressure.

"Liquidity has always been an argument for buying these vehicles, and although they are in principle liquid, in reality they don’t really trade as they are yield instruments. That means to build a position costs more and to exit costs more," said Wilson.

Amid the volatile market backdrop, in which private equity vehicles are being hit hard on concerns that they no longer have access to cheap credit, and structured credit funds are in turmoil on sub-prime losses, some have been able to differentiate themselves. BH Macro has proved to be a defensive instrument in a volatile market, while Boussard & Gavaudan Holding was able to return to the equity capital markets earlier this year to add a further €530m to the €440m raised through its November 2006 flotation. The deal gave encouragement to the market as more than half of the follow-on offer found its way to new investors.

"To get that sort of ticket from new investors should be viewed as a huge success. The only reason that B&G was able to come back to the market is that it has been doing what it should do in terms of performance," said James.

B&G Holding has been one of the better performing of the listed funds, showing a 15% increase in NAV between the IPO and follow-on, with the shares trading at an average 0.89% premium through that time.

One criticism of B&G's IPO was that a large chunk of demand came from switching out of the private vehicle and into the publicly-listed entity, therefore the total amount of new money being raised would have been less that final deal proceeds of €440m. But the lead managers defend switching as an important factor in the fund's strong performance. While switching effectively cancels out a portion of the deal proceeds, support from those individuals that are closest to the fund and the manager is crucial for the success of any fund flotation.

"Successful fund listings tend to rely on a core group of key cornerstone investors who know the manager and who must be in the book in meaningful size. If the people who know you best aren't in the vehicle, then it's harder to convince others to come in," said Coben.

The initial enthusiasm with which ECM bankers chased transactions, is now starting to recede, with most houses finding distribution difficult, particularly given that lack of big ticket institutional interest. "These deals are easy to originate, but often very difficult to get done, and that's why ECM origination teams must be so disciplined in their deal selection," said Coben.

Many transactions have also relied on significant chunks of financing from the lead managing banks. Lehman had to up its investment in Lehman Private Equity Partners to €145m to get the €500m deal away, while joint leads AAR and UBS took €20m each. While it might get the deal through the door, bookrunner participation can leave a hefty overhang on the stock and limit performance. As such, bankers are advising managers to take a piecemeal approach to fund raisings.

"Quite a few bulge bracket investment banks were getting involved in the run up to KKR and for the six months that followed, inflating expectations of how much can be raised. Whilst size is good for liquidity and visibility, the best way to achieve this is to grow assets over a period of time rather than in one fell swoop. By looking after a fund after it has listed and then coming back to the market, the result is a more diversified shareholder base," said ABN AMRO's James.

"One thing that's easy to overlook, but extremely important is the composition of the shareholder base. If you have a diversified and happy shareholder base, they will drip feed money into the fund in the secondary market, which supports the valuation. If one investor type is dominant, it can create difficulties for the future," he added.

One thing that most of the listed funds have in common is their externally managed structure. Coben believes that this has been one of the biggest problems to poor performance. "Investors find an internally-managed fund to be more attractive, because they believe it gives them a monopoly claim on the franchise and on management. However, most PCVs have externally-managed structures, and this explains in part why so many of these deals have struggled or failed to complete," he said.

Greek banking group Marfin provided a rare internally managed fund opportunity with its ambitious €5.2bn transaction. Given the lack of transparency over target investments, many were sceptical, but with no management fees and a rare opportunity to invest in growth and consolidation in Greece and the Balkans, investors piled in.

Ultimately, investors bought into the management story and were prepared to pay up for the proven expertise of chairman Andreas Vgenopoulos. What was once a bank, has now become an internally managed fund of financial assets, and the relative ease with which it raised the required financing for non-specified acquisitions shows what investors are looking for when they pay for someone else to make the investment decisions.

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